Wednesday, January 19, 2011

How much cash is too much? Looking at Apple

In the midst of lots of news about Apple - Steve Jobs taking a leave of absence and a 78% surge in profits reported today - I saw this news story in the Wall Street Journal. The gist of the story is that a portfolio manager who has about $700 million in Apple's stock feels that it should pay out some or all of its $ 50 billion cash balance to investors. I do not know the portfolio manager mentioned in the article, Mr. Bonavico, and I hope that he was misquoted because what he is quoted as saying borders on corporate finance malpractice.

Here is what Mr. Bonavico is purported to have said:"...they (Apple) are leaving money on the table by having such a large cash balance well below their cost of capital. The cash is earning near zero." That is an absurd comparison. Apple's cost of capital is close to 9% but that is for its operating investments in software, hardware and its iTunes store. Cash is invested in near-riskless, liquid investments and the appropriate benchmark (or discount rate) to compare it to  is therefore what you would make on riskless, liquid investment. The three-month T.Bill rate currently is yielding 0.16% and that is all that cash has to make to break even (or to be a zero net present value investment). Cash is not a good or a bad investment. It is a neutral one.

Does that imply that all companies should be allowed to hold on to as much cash as they want to? Not at all. Clearly, some companies accumulate too much cash and their investors would be better off, if that cash were returned to them. The question of how much cash is too much cash is  a debate worth having.  To resolve this debate, though, you have to start off with a clear sense of how or why cash balances affect equity investors in a company. No investor in a company is ever hurt by cash being invested in low return, riskless assets (commercial paper, treasury bills). What investors should worry about is what the company may do with the cash: take bad investments or overpay with acquisitions. I would rather that the cash earn 0.16% in T.Bills than be invested in projects earning 6%, if the cost of capital for those projects is 9%. To make a judgment on whether to attach a "stupidity discount" to cash, investors should look at a company's track record. They should discount cash balances in the hands of companies that have a history of over reacting, poor investments and bad acquisitions. They should not discount cash balances in the hands of companies where managers are selective in their investments and have earned high returns (on both projects and for their investors). In fact, over the last decade, there have been several studies that have looked at how the market prices cash balances and the results support this proposition.

In the case of Apple, a company that has seen its market cap rise almost thirty-fold over the last decade while generating a return on invested capital that exceeds 30%, this debate to me is a no-brainer. Do you trust Apple's managers with your cash? In fact, the real question should be if you don't trust Apple's managers with your cash, what company would you trust with your cash? As an Apple investor (albeit with a lot less than $ 700 million invested) since 1999, I have no complaints and here are the three scenarios relating to cash that I can see unfolding:

a. Do no harm scenario: In this scenario, which is the one that Apple has practiced for the last decade, it invests, when it feels that it has a good product (iPod, iPhone, iPad etc.) to promote and holds on to cash when it does not. Continuing with this scenario does not hurt me, as long as they keep the hits coming. I don't get dividends, but who needs them when you get that price appreciation?
b. Dream scenario: In this one, Apple finds a way to invest its entire cash balance of $ 50 billion right now and manages to earn a 30% return on capital on this investment. While this would clearly jump start and increase value, it does not strike me as viable. A company, even one as good as Apple, just cannot create new products and investments out of thin air and then staff them successfully.
c. Nightmare scenario: In this one, Apple decides that the return on cash (less than 1%) is too low and decides to take operating investments or acquisitions that generate returns that are higher than 1% but lower than the cost of capital. This would be devastating for value. If Apple goes on an extended buying spree, acquiring companies at outrageous premiums, I would join Mr. Bonavico in demanding my cash back.
d. Listen to Mr. Bonavico scenario: In this one, Apple returns $ 50 billion in dividends immediately. As an investor, I will get a big check in the mail (for dividends) on which I will have to pay taxes, but the stock price will decline by roughly the dividend. In fact, there is a very real chance that a big payout could be viewed by the market as a negative signal of future prospects and that the stock price could drop by more. (If the alternative is a stock buyback, the same problems exist though they will manifest themselves in a different way)

I have an extended paper on the value of cash and cross holdings (another widely misunderstood asset) that you can access at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=841485
Have a go at it!

34 comments:

Mike said...

Thank you professor, very informative article.

If the alternative is a stock buyback, the same problems exist though they will manifest themselves in a different way.
Could you eleborate on this?

My thinking is that AAPL can return part of the cash by way of stock buyback- thereby increasing the stock price without causing tax implications.
Trusting AAPL with cash: I can understand why the big investors might be uncomfortable with this proposition, especially when there is a change in management.

Aswath Damodaran said...

For a stock buyback to change the stock price on a permanent basis, it has to change something about the company: its operations or its financing mix. Apple's operations cannot be positive affected by a buyback though it is possible there will be no negative effects either. The cost of capital will remain unchanged, since Apple has no debt and will continue to have no debt after the buyback (unless you are proposing that they borrow to do the buyback).
Your point about management change is a good one. The departure of Steve Jobs should make us all nervous and I will be watching the new management closely. I am willing to give them a chance, before jumping ship, though. My fear with Jobs gone is not a breakdown in operations but a loss of imagination. The man may have had his faults but he was always able to think out of the box.

Matt said...

In the current environment, I think corporations have an incentive to hold cash due to future uncertainties. This certainly worked to Ford's benefit. They are essentially acting as their own banker.

Mike said...

Hi Prof,

Stock buyback means that the company earnings are now split among fewer shares, resulting in higher EPS.
Does'nt this impact the stock price positively and benefit the shareholders?

I would appreciate if you could enlighten me on this aspect.

Aswath Damodaran said...

But the company is riskier without the cash. Unless the market is completely ignoring this fact, the cost of equity will rise to offset the EPS increase.

Mike said...

Point well taken - riskier without the cash..

May be I was not clear earlier. Let me try again...
I was not suggesting that AAPL drain the cash completely via stock repurchase. My suggestion is: May be use up a few billions out of 50B in buyback to make shareholders happy.

Gaurav said...

Ex cash of $65/share, Apple is trading at 11.5x PE, assuming 2011 EPS of $24, which is where consensus is headed. If Apple can really repatriate all its foreign cash tax-free and do a share buyback with all it has on its books, then the stock at 11.5x PE will look very cheap for a hyper growth company. If the multiple expands to 14x, then one can make another $60/share, or roughly 18% per share.

Your essential argument is that markets are efficient and the current Apple stock price accurately reflects its future prospects, cost of capital and long-term capital structure. So playing around with the capital structure wouldn't do anything to the stock price assuming no tax benefits or leakage. That might be true in theory, but is unfortunately not true in reality.

To create a scenario, if Apple levers itself up 3x on 2011E EBITDA of $30bn and does a $150bn buyback at $350/share, it can buyback 428mn shares. Net share count become 500mn. On the $90bn debt, assume 8% for 10 year debt (companies are raising at lesser rates), and 30% tax rate, and one will end up with a $34 2011E EPS for Apple. At that time, Apple will be trading at 10x, for a very interesting deleveraging story which will delever to <2x Debt/EBITDA within a year, and the stock will cross $450.

Theoretically, it shouldn't happen because of more riskiness etc, so stock should remain around $340. But practically it will. I guess that is anyway how the KKR's and BX's have made their money - theoretically they shouldn't have made any money.

Krishnan said...

Prof.

Great Writing (again)

Whilst reading this post my mind went back to your book "Dark Side of Valuations"; Here what kind of a premium does one attach to someone like Steve Jobs, God forbid (I don't want to think) something happens, it will definitely affect the stock in the short run, do you think it may harm it in the long run as well?

Unlike other listed Giants, where (small) investors do not concern themselves too much with the second line of management, Apple is perhaps the only company where people keep tracking the man more than the company.

Your thoughts please...

Thanks, Krishnan

Aswath Damodaran said...

Any cash paid out (whether it is a little or a lot) will affect equity risk and make the cost of equity higher. As for Gaurav's point, I am not making any points about market efficiency. It is just plain common sense. Do you think Apple is being punished now for holding $ 50 billion in cash? I don't think so. If it is not being punished, then why would yo think that there is value creation at play when the cash is returned. (Remember that there is no talk of Apple borrowing money to buy back stock. If that were the case, there would be a change in capital structure. If not, the debt ratio stays at 0%)

RW said...

Dear Prof

Being part of corporate finance team of a company, I see this conflict often. There are investors who always want you to take riskier steps for earnings growth. Most of these don't care about whether you took more risk to earn a higher return. Their belief is that, in the short term at least, market would rewards the equity holders with a higher price. There is (often) a time lag between actual change in risk profile of a company and the time when markets realizes that risks have gone up in a systemic manner. Most likely this realization dawns on the marginal investor, when earnings or/and growth start to go in the other direction.

Such investors always have an option to sell out/switch loyalties. Most believe they can spot the turn and move out immediately Greater fool theory. Whereas promoters and other long term holders which sometimes includes management (well management could belong to the first category as well) are left to bear the consequences.

k

al said...

Professor Damodaran,

I don't see clearly why reducing cash increases the cost of equity, since as you stated earlier there is no change in capital structure.

However, I understand that the consolidated cost of equity in the consolidate valuation will increase to equal the cost of equity of the separated valuation.(ch16 in your Investment Valuation)

As I understand, buy back with cash does not change the share price. Indeed,

share price = (NPV + cash)/#shares

but after buyback cash = 0 and the reduced #shares keeps share price invariant.

Off course there is signaling in buy backs signals that will change share price.

Eric said...

Professor, with all due respect, shouldn't the market punish Apple for holding cash? Current Cash yields are below inflation, as the Fed uses its considerable power to push long-term rates down. Sure, cash has option value, but aren't you making an assumption that the option value offsets the expected decline in purchasing power one associates with cash?

Thank you.

Aswath Damodaran said...

If you have no debt, your beta as a company is a weighted average of the beta of your operating assets and the beta of your cash holdings. For instance, Apple is worth about $ 310 billion, $ 50 billion of which is cash. Assume that its current beta of 1.30
Beta for Apple = 1.30 = beta for operating assets (260/310) + 0 (50/310)
Now let's assume you pay the cash out. The beta for Apple will have to go up after the payout
New beta = 1.30/ (1-50/310)=1.55

Aswath Damodaran said...

Eric,
That is an interesting question. We all hold cash, including most portfolio managers. If the rate that we are earning is below the inflation rate, we are being punished but we are willing victims. Perhaps, we should be holding other securities instead. I am afraid that Apple, like every one of us, is a price taker on this one. You've heard the old saying. You can't fight the Fed.

Gaurav said...

Prof, in this statement - "Do you think Apple is being punished now for holding $50 billion in cash?" - there is an implied assumption of market efficiency.

Danny said...

Professor, very good article. I like what you remarked at the end about the effect of a possible big payout.

What you mention "there is a very real chance that a big payout could be viewed by the market as a negative signal of future prospects and that the stock price could drop by more" is what happened to Microsoft at the end of 2004, when they payout approx 20B on Nov 15th 2004, and the stock price drop by the end of the month and by the end of 2004, proving in some way that the company didn't have new investment opportunities.
We cannot know what would have happened if Microsoft didn't pay that big dividend, but we can look close to Apple's evolution, where I agree it isn't hurting stockholders.

recon.lallu said...

well i cannot disagree more... i dont know much about taxation.. but taxing dividends after taxing profits should be classified as robbery

ideally investors should have a choice and dividends are the most democratic way of addressing this

investors shouldnt be bluntly asked to accede their mediocrity against the company's 'best and the finest (from a historical perspective)'

Parijat said...

Professor,

None of the reasons for holding cash that you list in your paper seem applicable to Apple. They are generating over $9B in operating cash every quarter... so even if they want to acquire something, why keep $60B in reserve? Unless they want to buy Facebook for cash. Surely, of all companies, Apple would not have difficulty accessing the capital markets.

The only applicable reason seems to be the desire for empire-building or the thinking that the management is smarter than the investors. Why should the management be taking a portfolio decision for me (by investing such a large chunk in fixed income securities).

As Mike said.. they should certainly consider returning some of the cash. And also put on some long-term debt perhaps?

Mike said...

Parijat,

You have brought up an interesting point. Debt.

I am a novice to finance. I have read and heard that Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money..

As you said, in AAPL's case, the thinking might be that 'the management is smarter than the investors'. Professor seems to concur with this.

Aswath Damodaran said...

Mike,
Debt is always cheaper than equity for every firm but it does not follow that increasing your debt ratio will increase firm value. In fact, as you increase debt, both your cost of equity and debt will go up, and the cost of capital can actually increase.

Having said that, Apple does have debt capacity. It's current cost of capital is about 9% and it could be lowered to about 8.8%, if it goes to a 10%$ debt ratio. Increases beyond that actually push up the debt ratio.

But why bring up debt at this point? When you have a $ 50 billion cash balance, it is absurd to even talk about borrowing money unless you carry this to its logical limit. Do you want Apple to borrow $ 30 billion and buy back $ 80 billion in stock? That is not what Mr. Bonavico proposed (and what I responed to..)

Parijat said...

In that case.. if taking on $30B in debt would reduce cost of capital by 20 basis, why not use that 30B to buy back stock and retain the 50B in cash? So that still leaves them with the comfort of cash and lower cost. At an interest rate of say 7.5%, that's a cash outflow of about $560m every quarter.. which AAPL generates very comfortably anyway.

However, they now have $30B borrowed at 7.5% deployed at 1% (or lower) fixed income securities. This begins to sound patently absurd. (somehow cost of equity does not sound like a real cost to a lot of people. But turning it into debt requiring actual cash outflow gives it a different texture).

Is a cost of 6.5% (7.5% - 1%) per annum a reasonable one to have the comfort of a huge cash position?

Mike said...

Do you want Apple to borrow $ 30 billion and buy back $ 80 billion in stock? That is not what Mr. Bonavico proposed (and what I responded to)

This sounds like ideal situation -as opposed to leaving that amount of cash with the management- who knows, with that much cash, they might go and buy a few jets for themselves. : -)

Why are not the investors pressing for this course of action?

Mike said...

Parijat,

However, they now have $30B borrowed at 7.5% deployed at 1% (or lower) fixed income securities. This begins to sound patently absurd.

I see your point. But, the company will still have high positive cash flow and accounting profits. (Instead of making insanely huge profit, they will make huge profit). What if the lenders make some money by way of interest? The overall stability of the company will increase. My two cents...

Parijat said...
This comment has been removed by the author.
Parijat said...

Mike,

who knows, with that much cash, they might go and buy a few jets for themselves. : -)

Corporate Governance issues is exactly the problem with so much cash. That's where the faith in the management comes in. If they haven't done anything bad with the cash so far, they'll hopefully not do anything bad in the future.

Why are not the investors pressing for this course of action?

As a matter of fact, they are. The article is itself a response to one such demand.

About the debt bit. I am in fact saying that they should take on some debt. All I was pointing out was that when there is no debt, and hence no corresponding cash outflow towards the 'cost of capital', the situation does not sound as absurd as when you borrow money at 7.5% and deploy at 1%. Without the cash outflow, management probably does not really feel the true cost of capital.

In my opinion, there is nothing wrong with holding cash on your books. The question is one of scale. Since holding cash has a cost, one should carefully trade-off the cost with the commensurate benefits - such as ability to pounce of good opportunities etc. It's just that $60B is a huge amount of cash for an otherwise high positive cash-flow company. The context for how large $60B is can come from the recent implied $50B Facebook valuation - which Prof. Damodaran himself suggested is probably too high.

raj said...

Hi Professor,

Article was a nice reading.

I had a doubt. Don't you thinK Apple have 30% ROIC because $50 billion of cash is decreasing the non cash working capital used as denominator while calculating ROIC.
If cash is used somewhere else their ROIC will decrease drastically.

madhu said...

Sir,

What an investor should infer if a company announces a buyback when stock is at nearly 52 week high, solid cash position, share options outstanding as a % of share capital 5%-7% and the co has a leading position in its area of business?

joe said...
This comment has been removed by the author.
leboeufsurletoit said...

Prediction:

Apple will keep accumulating cash until it's cash pile is greater than than Microsoft's market cap....

Charles Morand said...

Prof. Damodaran:

Cash-rich tech cos have been on a buying spree over the past 18 months, whether for other cos of all sizes (Google/Motorola) or for patents (Everyone but Google/Nortel). In VC we have seen multiples widen as a result and the exit window is more widely open right now than it's been in a long time. However for the acquirers the risk of your "Nightmare Scenario" increases substantially in such periods. Do you know of recent studies or anyone in academia looking at this topic (i.e. how those acquisitions are performing in terms of ROIC?)

Chris Seilern said...

"Do you think Apple is being punished now for holding $ 50 billion in cash? I don't think so"

On the contrary, I think it might be the ONLY reason why the stock is trading at such a ludicrously low multiples.

Without getting into religious nit picking as to whether Apple's multiple is right or wrong, the inescapable fact here is that Apple has almost certainly the most future growth for the lowest multiple in its peer group of large cap tech names.

So why on earth would it want to use its huge cash pile on anything but its own operations?

And even if you were to ignore the logic of what should be done with the cash, you cannot escape the (im)practicality of the situation.

At $76 billion, AAPL's cash is nothing else than obscene. In fact there are only 71 companies on planet earth that have a market cap larger than that, and only 9 of those are Tech companies.

So the ONLY thing Apple could do that would make a huge difference to its cash pile would be (a) buy an elephant Tech company, or (b) buy Facebook.

Clearly, Apple buying IBM or Cisco is about as likely as Apple buying the Vatican. But buying Facebook is not devoid of sense. In the end, however, it intuitively does not correlate to what the company does.

So we are back to Mr Bonavico's question, and I think here what Prof. Damodaran has missed is that Mr Bonavico was not complaining about relative costs and returns of investments, but, instead he was complaining about Apple being the asset allocator.

Mr Bonavico probably quite rightly thinks that HE, not Apple, is the guy whose right it is to allocate his capital into whatever asset class he choses.

Clearly, here we are WAAAAY beyond any normal scenario and there is NO good reason why Apple should hold on to a lot of this cash.

The level of excess cash here is so ridiculous here that you could probably HALVE the cash pile without making AAPL any riskier (yes, I get the Beta rising point, but that ignores the fact that Beta is market relative measure and that instrinsic corporate value is an absolute value. So yes, less cash is worse than more cash, but în the context of Apple's insanely productive investments, that difference is nothing but a rounding error - 20bps on 50 billion is $100 million, or 0.28% of their FY11e EBITDA).

What I am saying is that, operationally, Apple with $20 billion is pretty much the same as Apple with $76 billion. So why not let Mr Bonavico get his money, and let Apple investors sleep at night by removing their main source of worry, namely that Apple will do something stupid with its cash?

Whatever Apple ends up chosing though, this situation will resolve itself whether people like it or not, because right now, cash is growing 1.5-2.0x times quicker than the market value of the Equity.

My bet? a whopping buyback.

S.E.B & J.A.D. said...

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Well, I didn't know it but despite these technical and commercial successes, Microsoft and Intel began to rapidly lower Apple's market share with the Windows 95 operating system and Pentium processors, so I think you should add something about that issue.

Willard C.Wix said...

Great article and right to the point. I don't know if this is really the best place to ask but do you people have any thoughts on where to hire some professional writers? Thank you :)
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Transformação said...

The issue here like many said before is who should be allocating that cash and IMHO it should NOT be apple. There is no operating reason to keep that cash around and I hope they do not buy anything just because they have cash. This should be returned to the investor and even if that lower the value of the stock by an equal amount that money will be generating better results (than Tbills) in my other investments.